Ever since the $50 billion Madoff Securities Ponzi scheme came to light, I have been wondering whether there are others out there that have yet to be discovered. While the facts of how Madoff was able to keep his scheme going remain elusive, it appears that a recent $7 billion cash call made it clear that he did not have enough cash on hand. If Madoff was indeed a Ponzi scheme, he would have needed to raise $7 billion from new investors to meet those redemption requests -- since he could not raise that much new money he folded his hand.
It is hard to believe that Madoff is the only scam artist out there. Why was Madoff able to pull it off for so long? Are there other funds with similar characteristics? Is James Simons' $35.4 billion (October 2007 assets under management) Renaissance Technologies such a fund? The answer to the last question is that it's possible but unlikely.
Since enough is not yet known about where Madoff's money came from and where it went, we don't know how he pulled it off. But, as I posted, there are four key elements that probably contributed:
- Unrealistically steady returns that others could not duplicate. Madoff reported 1% a month returns through a split conversion strategy that others could not duplicate but that investors wanted to believe was real;
- Lack of independent auditing. Madoff had a three-person audit firm -- one of whose members was a 78-year- old living in Florida;
- Weak financial controls. Madoff controlled trading, custodianship, and reporting; and
- Club marketing. Madoff created an aura of exclusivity about investing which made people feel that giving him their money was like being admitted to a prestigious club.
James Simons -- a math genius who taught in Harvard's math department -- is one of the most successful investors alive if reporting on him is accurate. His Renaissance Technologies -- which is staffed by PhD mathematicians and scientists -- managed $35.4 billion as of October 2007, and it charges a 5% management fee and 36% of profits compared with the industry standards of 2% and 20%. In 2006, Simons made $1.7 billion and between 1996 and 2007 his funds earned 43.6% annualized annual returns, net of fees. In the first three quarters of 2008 his $8 billion Medallion Fund was up 58%.
What does Simons have in common with Madoff? There is one area where Simons and Madoff share a common attribute -- nobody can figure out how they make (or in Madoff's case made) money. However, there is also a crucial difference -- Simons does not have outside investors (he returned the capital of outside investors in 2005) -- Renaissance is run completely for the benefit of its employees.
If Renaissance borrows money, then its lenders could be at risk if Renaissance is not what it claims to be. Otherwise, the biggest losers would be its employees. Nevertheless, Renaissance is quite intense when it comes to secrecy -- just as Madoff was. In 2003, Simons sued two former employees whom he fired for not signing non-compete contracts. They revealed some information about three of his strategies.
In one such strategy Renaissance uses something called limit order book data -- information on trades that have not yet happened. If a fund could get access to such data, it would be a form of inside (but possibly legal) information -- profiting from the knowledge of a trade that is about to happen.
For example, a fund firm could look at such data and identify a large sell order for a stock that was trading at $15.05 -- but the sell order was for $15 a share. The fund could sell the stock short at $15.01 and then cover its position when the sell order was executed at $15 -- making a penny a share in profit.
My hunch is that Simons could be one of those rare people who really is able to beat the market by a wide margin consistently. But as the Long-Term Capital Management fiasco proves, simply hiring math geniuses does not mean you will always win. Nevertheless, if it's true that Simons does not have outside investors, if his fund is a scam he would only be hurting himself and his employees.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.
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Reader Comments (Page 1 of 1)
12-21-2008 @ 1:25PM
DP said...
How does one obtain limit order book data? So basically this guy is using non-public info to beat the market? I guess they teach and reward cheating at Harvard's math department which explains a lot about America's prestige and why the rest of the world hates us...
12-22-2008 @ 10:13PM
Phil said...
"if his fund is a scam he would only be hurting himself and his employees"
Cui bono? Why throw that out there without evidence of malfeasance?
12-26-2008 @ 10:42AM
BS on Wall Street said...
Harvard ??. Get your facts right. I have never heard from anyone that Jim Simmons has any connection with Harvard. Jim taught at Stony Brook.
12-29-2008 @ 1:12PM
spinfire said...
Full depth-of-book limit order information is usually available from the market center, although it is heavy in volume (data bandwidth) and must be consumed in real-time if you want to use a strategy like this.
12-29-2008 @ 3:17PM
yair marx said...
not entirely true, simon's medallion fund is only made up of his and his employees money. he has other funds that have outside investors like a regular hedge fund.
1-19-2009 @ 12:27PM
cheeto said...
pl.just visit the link to know all about mandoff part II http://www.forbes.com/lists/2006/10/5GZ7.html
1-24-2009 @ 6:21PM
shark said...
Is Peter Cohan the next ponzi zar? Cohan, who has probably never met Simons, never further researched his strategy, setup and methodology, etc. dares to write something like this? YOU HAVE NO CLUE AND YOU SUSPECT A RESPECTED MANAGER WITH PONZI! I could go on for hours what else is substantially different. And even more I see his trades and he is making money. Big time sometimes. Why don't shut up instead of bullshiting around in an area where one really doesn't have a clue? Keep on buying stock dips as CNBC bubblevision has been telling you... sorry, but this is disgusting. you have no evidence nothing and throw dirt at Simons. Shame on you. And then you compare it to LTCM. Wow, again portfolio and strategy with not the least similarity to Simons. bullshit, bullshit, bullshit...
3-10-2009 @ 3:40AM
rufus said...
your example about limit order book is factually wrong (and yes, i am an exchange member), it is as smple as that. first of all, these is no such thing as stock trading at 15.05, it would be say trading at 15.05 bid and 15.06 ask (inside market), and last executed at 15.05 (which ppl commonly, and mistakenly, refer to as "trading at 15.05"). So any sell order at $15 flat would be executed immediately, with zero chance of RenTech (or anyone) stepping in *front* of the order. Yes, there are strategies that "tags along" with large order flows, but that's common knowledge for anyone that has been on an institutional trading desk.
and if anyone is curious about "limit order book shuffling" type of strategy, just type "limit order book market microstructure" into Google, and read up on it. There is no big mystery. Of cos, RenTech's ability to trade in so many markets, high frequency in real time is impressive, but nothing "extra-ordinary" about it. There are a number of funds / trading firms doing similar things on a smaller scale.
Furthermore, if you are talking about Medallion, it is merely closed, there *are* outside investors, it is just not open to any new investors since I believe 1995. There are several funds, Institutional Equity being one, that is open to new investors.